Live Oak Bancshares, Inc. Q3 FY2022 Earnings Call

Thank you for standing by, and welcome to Live Oak Bancshares Third Quarter 2022 Earnings Conference Call. [Operator Instructions] I would now like to hand the conference over to General Counsel and Chief Risk Officer at Live Oak Bank, Greg Seward.

Thank you, and good morning, everyone. Welcome to Live Oak's Third Quarter 2022 Earnings Conference Call. We are webcasting live over the Internet, and this call is being recorded. To access the call over the Internet and review the presentation materials that we will reference on the call, please visit our website at investor.liveoakbank.com and go to today's call on our event calendar for supporting materials. Our third quarter earnings release is also available on our website. Before we get started, I would like to caution you that we may make forward-looking statements during today's call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from our expectations are detailed in the materials accompanying this call and in our SEC filings. We do not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of today's call. Information about any non-GAAP financial measures referenced, including reconciliation of those measures to GAAP measures, can also be found in our SEC filings and in the presentation materials.

Thanks, Greg, and good morning, all. I will kick off today's earnings call describing how we think about capital and a potentially declining economy, followed by BJ on results, and we'll close with Huntley describing how we operate the business and where we are going. Let's move to the next slide. Here are some household names indicating a recession may be around the corner. Bezos says batten down the hatches. Goldman's CEO says, there's a good chance for a recession. And Jamie Dimon says, a recession is likely in the next 6 to 9 months. Next slide. Certainly, the world is not coming to an end. It is our belief that capital is king in any environment. Therefore, a properly managed balance sheet yields a flight to quality for our customers, our folks and you, our shareholders. None of us has a crystal ball. There is little doubt that uncertainty is everywhere from runaway inflation to higher interest rates to an unsettling political environment, and we could go on and on. The truth is we operate one of the most highly leveraged, highly regulated businesses on the planet. In the baseball business, batting 400 gets you to in the hall of fame. Making 60% of your shots in basketball does the same thing. In our business, making good loans over 99% of the time is essential. Let's talk about recessions on the next slide. Reflecting on the recessions that I have lived through, one glaringly comes to mind, and that is the third from the bottom, the recession in the early 2000s. I had started an Internet banking software company in the late '90s, and I was sitting on the runway at Atlanta's Hartsfield Airport, enroute to meet with the senior management team at the ABN AMRO Bank in Amsterdam. We were #25 for takeoff. My company's market cap was higher than Delta's, and we were losing $60 million a year. How could that possibly be? I met with the ABN AMRO team at the airport for an hour, took the same plane back to Atlanta and called an emergency Board meeting. In the next several weeks, we raised over $300 million from our customers that were using our software and not from Wall Street, then the dotcom crash. Without that capital, I'm not sure the company would have survived. Recessions provide lessons learned. We are often asked, how will your small business customers handle the downturn? How will your origination engine operate? If the past is a proxy for the future, how have we managed your balance sheet these past 14 years? Let's take a look at that on the next slide.

Excellent. Thanks, Chip. Good morning, everybody. We'll start with quarter highlights on Slide 13. As you can see, our earnings per share were $0.96, driven by strong net interest income and loan growth, which we'll talk about a little bit more. And of course, the previously announced Payrails gain. Net interest margin of $3.84 held up very well again in the quarter, declining just 5 basis points from the second quarter despite 150 basis points of rate hikes during the third quarter. Our net interest income growth, you'll see is up 26% year-over-year on 23% loan growth. Loan production, again, changed $1 billion and pipelines are still near all-time highs and credit quality remains quite strong despite the uncertainty of the economic outlook. Our core business performance, along with continued success with our ventures investing, as Chip highlighted, continues to add significant tangible book value per share at 15% year-over-year. Turning to Slide 14. You see our adjusted results and the notable items that make up those adjustments. The biggest which, of course, is the Payrails gain. Another one I'll quickly highlight is the renewable energy tax credit impairment as we've had a few of these over the last several quarters. These investments are a good thing and a net positive. When we make these investments, the accounting treatment is to impair a substantial portion of it immediately, which flows through the expense line. This is more than offset by a larger reduction to our tax expense and effective tax rate over the course of the same year. That is why we adjust out the expense when looking at adjusted PPNR or pretax earnings and also while our effective tax rate is lower than statutory rates. We'll continue to have more of these investments from time to time, including one in the fourth quarter that we currently estimate to be about $12 million. Adjusted PPNR was up 21% due to strong net interest income growth of 5% linked quarter and higher fee income driven by $9 million of gain on sale income versus $5 million in Q2, which more than offset continued investment in people and technology. As I said earlier, credit remains quite healthy, while our allowance for credit loss reserve coverage stayed steady overall at 123 basis points, net charge-offs were actually lower in the quarter to only $1.7 million. Provision was up quarter-to-quarter due to strong loan growth, along with portfolio and macroeconomic changes as we proactively look ahead to a potentially less benign credit environment. Breaking down the components of revenue on Slide 15. You'll see total revenue growth up 12% year-over-year despite significantly lower gain on sale income, thanks to 26% year-over-year growth in net interest income. As we discussed on last quarter's call, we've seen secondary market dynamics for guaranteed level sales shifting rapidly due to the current aggressive Fed rate tightening cycle. As you know, we moderated sales in the second quarter. And this quarter, we saw modestly better opportunities in SBA variable rate sales, but the market for fixed rate sales remains unattractive. Again, it's important to understand that this income is not permanently lost. We simply earn it over time in the form of spread income as evidenced by our strong loan and net interest income growth. Because of the flexibility we have with strong capital and liquidity levels, we are more than happy to hold more high-quality assets and will remain patient with secondary market sales until further normalization.

Thanks, BJ. I'm going to wrap up today by focusing on 3 questions. The first is how our small businesses are doing overall. The second is what's the opportunity for us at Live Oak to serve them. And then third, what are we doing to address that? We get a lot of questions about the overall health of small business given where we sit. And 3 years ago, we started a quarterly survey of small businesses, along with Barlow Associates. It's one of the preeminent research firms serving small businesses. And we wanted to share a bit of information from their most recent survey to give you a sense of how small businesses are feeling, but also it indicates some of the opportunities that we have to serve them. People say that we're at the tip of the spear as it relates to small business in America. And if that's the case, so far, small businesses are waging a pretty impressive battle. So on Page 23, you can see the overall sentiment certainly has deteriorated, which shouldn't come as any surprise. Although interestingly, it looks as if views on the economy may have bottomed out recently, although they still remain decidedly negative. Expectations of the financial performance of companies have also deteriorated but remain more positive than views of the overall economy. It's clear that the majority of small businesses expect a slowdown and are positioning themselves for a weakening economy. And that's still in contrast, as Chip and B.J. referenced, with our current credit performance, which remains outstanding. Looking at the right-hand side of this page, we see that only 20% of the surveyed small businesses applied for credit in the past year. And if you drill down a layer deeper into that data, you'll see that the majority of those that applied apply for working capital, not the growth capital that we typically provide. So the opportunity for us to serve small businesses with working capital products and deposits can dramatically expand our addressable market.

I want to start first on the cost of deposits. If we look at the cost of interest-bearing deposits, it is around 1.5% in the quarter. If we look at your online rates, it looks like it's between 2.75%, 3.75%. So first, how quick does the overall cost of interest-bearing deposits move into that range? And do you expect more incremental funding to come from the online savings, right, which is the lower end, or more from CDs, which is the upper end?

Steve, it's BJ. So our team has really done a great job managing deposit rates up through this point. It started off slow in terms of beta as we all would have imagined, but it's significantly heated up probably in the last 4 quarters. What helped in terms of our overall deposit costs, both last quarter and this quarter is that a lot of the big moves in rates from the Fed happened towards the latter part of the quarter, which meant that there wasn't nearly as big of an impact on the overall portfolio in the quarter as you would have expected. I think now with the Fed moving earlier in the quarter, going into the fourth as well as what they did in the third, you're going to start to see our portfolio costs move more towards where our spot rates are today. In terms of the mix, we still believe that savings is really where we're seeing most of the volume. We have had and tried some attractive offers more in the 12 to 24 month range on the CD side, but there just hasn't been a lot of appetite for that, given how rapidly online savings rates have been going up. So we certainly expect deposit cost to continue to rise, but on the left side of the balance sheet, loan yields, we are very, very pleased with what our lending officers have been able to do to adjust quickly. We're seeing loan yields really start to move. October 1st was a big deal for us because that's when our quarterly adjusting loans, of which we have quite a bit, adjust up 150 basis points. So our loan yields are keeping up with our deposit costs growing, and that's why we've been able to do such a good job on holding the net interest margin, and we expect that to continue.

So I'll start that, and you guys can add to that. I mean, I think what we have talked to our lending officers about. And remember, our lending officer base is expanding daily. I mean we've added, what, 12 or 15 lending officers just this year, primarily in the SBA area. And certainly, the secondary market for fixed rate SBA paper has been a blood bath and a disaster recently. And so our lending officers are now being quite successful on the variable rate side because there are a number of borrowers out there that are saying, like, this thing may turn. Maybe I should not take an 8% 25-year fixed rate, maybe ought to get a low floater here. And then the prices for those loans in the SBA second day market have held up and are coming back quite nicely. So I think we're seeing more lending officers being more aggressive on, a bit lower, right, not 2 or 2.5 over prime, but something slightly less than that. And I think we'll see that continue over the next several quarters.

[Operator Instructions] Our first question comes from the line of Steven Alexopoulos of JPMorgan.

I wanted to start on the business second launch. So the customers are already up to 1,300. It sounds like from the 70, 75 at the end of the quarter. I mean, do you guys have a sense of like what the average balances on these deposits that are coming over as we try to type of frame a growth opportunity here over a realistic time period?

Yes, Mike, sure. So we've got about $10 million in balance across 1,300 accounts. So they're in the $5,000 to $10,000. The majority of them are in the $5,000 to $10,000 range. So like we said, the smaller end of small business right now. And that's what we're seeing. I think as we go to market, ideally start to push up a bit with that. But like we said on the call, this product doesn't have the treasury management capabilities some of the largest small businesses need, and we'll be coming at that end of the market in the first quarter, which we think is where we'll get to some of the more significant balances in the market.

Thanks to everyone for joining this morning's call. And as always, we'll see you in 90 days.

This concludes today's conference call. Thank you for participating. You may now disconnect.